ProfessorBainbridge.com

Are Two Heads Better than One?

Chicago Tribune columnist Andrew Leckey argues:

Corporate governance is generally best served if separate people are in the roles of chairman and CEO.

The chairman should be closely involved with the board and able to work out issues in a more detached manner than a CEO on the daily firing line. The chairman should have a broad perspective on the organization and the confidence to observe, offer advice and push for decisions that may not please the CEO.

Setting aside the question of whether anyone would take corporate governance advice from anybody who works for a company as messed up as the Tribune, as we saw last week there is little "evidence that separating the two roles improves corporate performance and/or has a positive stock price effect."

Losing Sight of the Issue

As I predicted, the media frenzy at HP is now focusing on who knew what about the leak investigation and when they knew it. Incensed that some in the MSM tribe were investigated, the media is exclusively focusing on the investigation. What we've lost sight of in all this, is that the investigation never would have been necessary if George Keyworth hadn't violated his fiduciary duties of confidentiality by leaking information to the press.

Duckhorn Merlot (Napa Valley) 1999

A couple of earlier notes ( Feb. 04 and Jan. 05). It continues to evolve and is likely to do so for more years than I originally estimated. This bottle was in prime drinking condition (of course, it had gone straight from the winery to my cellar). The tannins are smooth, the acids are well integrated, but there's still a lot of dark berry and black cherry fruit, as well as more mature flavor associations such as tobacco leaf and truffles. With half a case left in my cellar, I'm a very happy camper. At this point, I plan to dole out a bottle a year until I decide the wine has finally started going downhill. My current guess is that, at that rate, I'll be out of bottles before the wine is past its expiration date. At $45, this was a real bargain. Grade: A

Herzog Special Reserve Cabernet Sauvignon (Napa Valley) 2002

This wine is kosher for Passover, but not recommended. An odd, medicinal note on the nose. The fruit is vegetal (sauerkraut?) and industrial. Yuck. There is a saying that you should never cook with a wine you wouldn't drink; this wine went into the pot, but I hesitated before doing so, which tells you something. Grade: D

Law Firm Interview Stories

It's job interviewing season here at UCLAW, as at all other US law schools. Which brings to mind two true stories from my days at as a University of Virginia law student interviewing for jobs with law firms:

1. I had an on campus interview in Charlottesville with the Washington DC office of a law firm whose initials are CW&T on a Monday. On Tuesday, I received a rejection letter - whose postmark indicated it had been mailed Monday evening from Charlottesville. Ouch.
2. A week or so after an on campus interview with the Washington DC office law firm whose initials then were H&S (and now are HSAW), I got two letters. One invited me up to the DC office for a call back. The other was a rejection letter. I called up the hiring partner, who had signed both letters, to ask which one was the right one. After a lengthy and rather pregnant pause, I was informed that the rejection letter was the real one. Not quite as much of an ouchie, but still ....

The Excessive Emphasis on Agency Costs in Corporate Governance

In my scholarship, I have frequently argued that corporate law academics overemphasize agency costs. (The gist of my argument is that accountability measures designed to reduce agency costs necessarily infringe on the competing value of authority.) Now come two prominent scholars - Robert Rasmussen and Doug Baird - who also criticize the focus on agency costs, albeit from a different angle:

Agency costs dominate academic thinking about corporate governance. The central challenge is to devise legal rules to align the interests of the managers (the agents) with those of the shareholders (the principals). This preoccupation is misplaced. Whether it is finding a baby-sitter or a dean, the challenge of hiring the right person dwarfs the challenge of aligning that person's incentives. The central task for corporate governance – its Prime Directive – is to ensure that the right person is running the business. In this essay, we suggest that the challenge of aligning the managers' incentives has been drastically overstated and the way in which legal rules affect hiring (and firing) decisions has been too often ignored.

Putting the emphasis on agency costs may lead to rules that slight what matters most. The current preoccupation with executive compensation runs the risk of inducing the board to worry more about the details of the employment contract rather than selecting the best person in the first instance. More important, the law can play an important role ensuring bad managers are fired. Once hired, all managers need to be mentored, monitored and, when necessary, replaced. There is little to suggest that a single entity is well-situated to perform all three. There is tension between the roles of confidant and policeman. Here, debt contracts play a crucial and largely neglected role. Covenants in debt contracts can insure that underperforming managers are called to task. Private debt holders' role in monitoring a business and ensuring that underperforming managers are replaced may be as important as the market for corporate control.

More on this provocative argument later.

Cars, Public Nuisances, and Global Warming: Bill Lockyer's Latest Abuse of Power

Hoping to emulate NY attorney general's Eliot Spitzer's rise to political prominence, California attorney general Bill Lockyer has been busy sticking his nose into a host of places it doesn't belong. For example, announcing that he has evidence to indict people in connection with the spying "scandal" at HP. Now he's filed a "lawsuit against leading U.S. and Japanese auto manufacturers, alleging their vehicles’ emissions have contributed significantly to global warming, harmed the resources, infrastructure and environmental health of California, and cost the state millions of dollars to address current and future effects." The premise of the suit is that the cars are a public nuisance; i.e., "an unreasonable interference with a public right, or an action that interferes with or causes harm to life, health or property."

This follows an earlier suit by Lockyer against power companies on much the same theory. The basic problem is that Lockyer is trying to use the courts to decide what is really a political question. (The US Chamber of Commerce filed a great brief in the power company case explaining why the courts are not an appropriate forum for this sort of legislation by adjudication; it's recommended reading.)

The court before whom Lockyer's suit has been filed should remember that Spitzer advanced a similar theory in a lawsuit against the gun industry. As the New York court explained in Spitzer v. Sturm, Ruger & Co., Inc., "Plaintiff State of New York, by its Attorney General, commenced this action with a complaint alleging that defendant corporations, which are handgun manufacturers, wholesalers and retailers, have created, contributed to, and maintained a public nuisance by their respective manufacturing, distributing and marketing practices." The court decisively rejected Spitzer's argument, holding that "the Legislative and Executive branches are better suited to address the societal problems concerning the already heavily regulated commercial activity at issue."

Plaintiff's attempt here to widen the range of common-law public nuisance claims in order to reach the legal handgun industry will not itself, if successful, engender a limitless number of public nuisance lawsuits by individuals against these particular defendants .... However, giving a green light to a common-law public nuisance cause of action today will, in our judgment, likely open the courthouse doors to a flood of limitless, similar theories of public nuisance, not only against these defendants, but also against a wide and varied array of other commercial and manufacturing enterprises and activities.

All a creative mind would need to do is construct a scenario describing a known or perceived harm of a sort that can somehow be said to relate back to the way a company or an industry makes, markets and/or sells its non-defective, lawful product or service, and a public nuisance claim would be conceived and a lawsuit born. A variety of such lawsuits would leave the starting gate to be welcomed into the legal arena to run their cumbersome course, their vast cost and tenuous reasoning notwithstanding. Indeed, such lawsuits employed to address a host of societal problems would be invited into the courthouse whether the problems they target are real or perceived; whether the problems are in some way caused by, or perhaps merely preceded by, the defendants' completely lawful business practices; regardless of the remoteness of their actual cause or of their foreseeability; and regardless of the existence, remoteness, nature and extent of any intervening causes between defendants' lawful commercial conduct and the alleged harm.

Summary dismissal would seem to be called for.

SOX and the Ugly American

The UK Financial Times reports on grumbling by UK firms about regulatory imperialism by the US SEC and PCAOB post-Sarbanes-Oxley:

Having US inspectors trawling through foreign audit firms must mean wasteful activity. Even where there is a high degree of co- operation, some repetition is bound to occur. And achieving this co- operation will not be possible without large amounts of time and effort that could have been directed elsewhere.

Extending the US writ in this way is offensive at a deeper level. This requirement of Sarbox amounts to telling audit regulators throughout the rest of the world that the US authorities do not believe they will do a proper job. Behaving as though you have a monopoly of virtue is rarely attractive and in this case is also misplaced, since Sarbox falls far short of a regulatory ideal. Even more fundamentally, it is unacceptable that legislators in one country can declare unilaterally that their law should run outside their - jurisdiction.

The obvious answer would be some form of reciprocity. If an audit firm has been approved by UK regulators, that ought to be good enough for the PCAOB.

"Who needs a board of directors, anyway?": A Reply

Fortune editor-at-large Justin Fox offers the provocative question: "Why do companies have boards of directors, anyway?" It's a very good question. Unfortunately, he offers a very bad answer. Go read his piece and then come back for my parsing.

Fox offers the following historical claim:

... as recently as the early 1900s, the board had a pretty clear function. It was the perch from which big shareholders and creditors watched carefully over the men they had hired to manage their companies (as is true today at companies controlled by private equity firms). But the very success of some of these pioneers of industrial capitalism led to the undoing of this model. Corporations outlived their founding shareholders, outgrew the need to borrow money, and, as the stock market captured the public imagination in the 1920s, found their shares in the hands of thousands of small investors in no position to watch carefully over anything. Managers naturally took charge, and boards became appendages entirely beholden to them.

As I explained in The Politics of Corporate Governance, however, this notion that there was a golden era in which ownership and control were united is a misreading of history. Economic separation of ownership and control in fact was a feature of American corporations almost from the beginning of the nation. Even in the antebellum period of the 19th Century, publicly held corporations already had all the essential elements of modern public corporations, as Walter Werner explained: "a tripartite internal government structure, a share market that dispersed shareholdings and divided ownership and control, and tendencies to centralize management in full-time administrators and to diminish participation of outside directors in management."

Fox then turns to the modern corporate governance arena, observing that:

... stock ownership was becoming reconcentrated in the hands of huge pension funds and mutual funds whose managers were far less patient and far more able to make their impatience known than small individual investors were.

Again, there's a factual error. As I explain in Shareholder Activism and Institutitonal Investors, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. These activists often are pursuing a private agenda not shared by and often in conflict with that of passive investors.

Finally, Fox offers two alternatives to the board, both of which he contends are impracticable: direct shareholder democracy and a unitary executive:

Because direct shareholder democracy isn't going to happen (the nation's CEOs would be violently opposed) and corporate monarchy, while perhaps a more honest representation of the true power relationship in corporations, just wouldn't feel right. "If you had self-perpetuating management and no representation, people would question why that was," [Gevurtz] says. "There's this feeling that managers shouldn't be in charge of these large aggregations of power, even though that's the way it is." So that's why companies have boards of directors: To make the rest of us accept their existence.

What Fox overlooks, however, is the very real economic function provided by having a small group - rather than either an individual autocrat or a large mass of voters - at the top of the corporate hierarchy. As I explained in Why a Board?:

The default statutory model of corporate governance contemplates not a single hierarch but rather a multi-member body that acts collegially. Why? This article reviews evidence that group decisionmaking is often preferable to that of individuals, focusing on evidence that groups are particularly likely to be more effective decisionmakers in settings analogous to those in which boards operate.

In sum, there are very good economic reasons for corporations to have boards of directors. Fox just needed to look harder.

Can Sarbanes-Oxley 404 be fixed? And why it matters - a lot

In testimony before Congress, both SEC Chairman Chris Cox and PCAOB Chairman Mark Olson testified, as Cox put it, that "those parts of SOX that aren’t working as well as they should – notably Section 404 – can be made to work better through better implementation." They're referring to Section 404 of the Sarbanes-Oxley Act, which requires companies to implement and certify extensive internal controls designed to ensure accurate disclosure of finaancial information. Compliance with section 404 has become vastly expensive - on the order of millions of dollars per year per company.

Although SOX 404 may seem like a dry and technical issue, let me remind you of what the stakes are. In a very important op-ed in today's W$J, Wharton finance professor Jeremy Siegel writes:

The United States and the rest of the developed world stand at a precipice. Over the next two decades, tens of millions of Americans, Europeans and Japanese -- members of the prosperous "baby boom" generation that was born following the Second World War -- will leave the labor force. Many are expecting a long and comfortable retirement by relying on government and private pension plans as well as tax-supported medical services.

But unless we can exploit the dramatic demographic and economic changes that are before us, our future will be much poorer. Instead of stepping into an easy retirement, many retirees will tumble into a future marked by bankrupt government social programs and declining asset values that will quickly deplete their cherished nest eggs. ...

Although it is widely known that our Social Security and Medicare Programs are threatened by these demographic trends, there are many who believe that they have accumulated sufficient private wealth to fund their retirement.

But this may not be so. The same crisis that strikes the public pension programs can overwhelm private pensions as well. Since there will not be enough workers earning income, there will not be enough savings generated to purchase the assets the retirees must sell to finance their retirement.

One solution, of course, would be an open borders policy that allowed young workers from developing countries to move here to offset the domestic demographic trends. Another, which is the one proposed by Siegel, is to attract masses of foreign capital:

The developing world has a much younger age profile than the developed world. This difference in age establishes an opportunity to make a trade: Goods produced by the younger developing world can be exchanged for assets of the older developed world. This trade is not new. The transfer of goods for assets has taken place throughout history, first between family members (parents giving to children in exchange for old-age support), and then extending to clans, communities and, finally, whole nations. Soon it can be done on a worldwide basis. The developing world has the capability of simultaneously providing us with goods and acquiring our assets, filling the gap left by our aging workers.

I call this the "global solution to the age wave" and it relies on huge global capital flows to be effective. My studies show the inflow of goods and services produced abroad in exchange for capital can have dramatic effects, reducing the projected retirement age in the U.S. from the mid-70s to the upper 60s.

Siegel then emphasizes the resulting implication for public policy:

For these capital movements to occur, we must be far more receptive to international capital. Although there has already been a large number of cross-country mergers, there has also been increasing opposition, witness Cnooc's bid for Unocal and the Dubai Ports fiasco. But if we rebuff goods or capital originating abroad, our growth will decline since we will be forced to rely only on our own dwindling supply of savings.

It's not just cross-border mergers that are at issue, however. Consider what's happened to IPOs:

So far this year, there have been just 17 international initial public offerings (IPOs) on the New York and Nasdaq stock markets, worth a mere $6bn in total. This is in stark contrast to the booming London IPO scene, where the London Stock Exchange (LSE) and its small-cap Alternative Investment Market (AIM) have grabbed 59 floats worth $16bn. It was not always thus: as recently as 2000, before the collapse of the dot.com bubble, 78 foreign firms listed in the United States, against just 12 in London.

Why is London attracting so much capital, while the US is lagging?

By a huge stroke of luck, ... the attractiveness of London’s main rival – New York – has collapsed at a much faster rate, thus boosting Britain’s competitiveness by default.

The Sarbanes-Oxley regime imposed by a short-sighted Congress in the wake of the Enron and WorldCom scandals can now be seen to be a gross over-reaction, making it excessively onerous to list on US stock exchanges or to raise capital in America. Sarbanes-Oxley’s complex and astonishingly prescriptive reporting requirements mean that international companies now much prefer the lighter touch regulation they encounter in London, a location they also find attractive for a wide variety of cultural, linguistic and time-zone reasons.

Section 404 is at the core of the problem. I have repeatedly documented the high costs domestic companies experience in complying with 404. In the long run, however, it may be that SOX 404's main detrimental effect is to make US capital markets far less attractive to foreign investors, at precisely the moment in our demographic history when we need foreign capital more than ever.

Instead of trying to band-aid the situation by yet another round of purported "fixes," Congress should simply repeal 404.

Doctors and Lawyers

From Point of Law:

In Waukegan, Ill., 49-year-old Beatrice Vance died of a heart attack after waiting two hours in a hospital waiting room. A coroner's jury has declared her death a homicide. (Lake County News-Sun, AP, Chicago Tribune). Medical blogs are discussing: GruntDoc, MedPundit, KevinMD.

Reading the comments from doctors on the medical blogs was quite informative. The MD's basic attitude seems to be "shit happens and lawyers suck."

Update: I'm persuaded by the arguments some have made against criminalizing malpractice. It's directly analogous to the problem of criminalizing agency costs in the corporate law context, a practice of which I have been critical.

Also, I was amused by the comments of a British medical blogger:

Over in the colonies, a more robust approach has been taken. Not by the government but by the lawyers. Day by day, the USA becomes ever more litigious and the beleaguered medical profession is a coconut-shy for lean, hungry and unsympathetic lawyers ....

Personally, I do think that "shit happens" and I agree entirely (as do some of the commentators on the Professor's website) that, in this context, American lawyers suck.

A "coconut-shy"? Can I get a translation, please? Anyway, Dr Crippenden sounds like a fun guy with whom to split a bottle of claret.

Is Online Dating Efficient?

As I approach my 20th wedding anniversary (next week), online dating is a topic of little personal interest. For the benefit of my readers who are still single, however, I pass along this recent SSRN post:

What Makes You Click? Mate Preferences and Matching Outcomes in Online Dating: This paper uses a novel data set obtained from an online dating service to draw inferences on mate preferences and to investigate the role played by these preferences in determining match outcomes and sorting patterns. The empirical analysis is based on a detailed record of the site users' attributes and their partner search, which allows us to estimate a rich preference specification that takes into account a large number of partner characteristics. Our revealed preference estimates complement many previous studies that are based on survey methods. In addition, we provide evidence on mate preferences that people might not truthfully reveal in a survey, in particular regarding race preferences. In order to examine the quantitative importance of the estimated preferences in the formation of matches, we simulate match outcomes using the Gale-Shapley algorithm and examine the resulting correlations in mate attributes. The Gale-Shapley algorithm predicts the online sorting patterns well. Therefore, the match outcomes in this online dating market appear to be approximately efficient in the Gale-Shapley sense. Using the Gale-Shapley algorithm, we also find that we can predict sorting patterns in actual marriages if we exclude the unobservable utility component in our preference specification when simulating match outcomes. One possible explanation for this finding suggests that search frictions play a role in the formation of marriages.

Insider Trading Frequency

There was a rather breathless report last week on the frequency with which insider trading occurs:

Insider trading of public companies that are bought through mergers or acquisitions occurs very frequently according to a study conducted by Measuredmarkets for the New York Times.

The researchers conducted the study by analyzing historical trading behavior. Surprisingly, 41 percent of all stocks that were bought with a market value greater than $1 billion showed suspicious trading activity just before buyout bids were made public. In these cases huge spikes in trading volume in the stocks and options on the stocks were identified. For example, in the days before bidders announced offers for Amegy Bancorp trading volume in the stock soared by 400 percent. The study’s findings indicate that insider trading is much more prevalent than ever thought.

More prevalent than who thought? In my insider trading scholarship, I've frequently noted that insider trading is rampant, is detected and prosecuted in a tiny fraction of cases, and probably is the most commonly committed violation of the securities laws. In any event, the report prompted my friend Henry Manne (the leading contrarian scholar of insider trading) to send along this email, which he kindly authorized me to reproduce here:

There are several problems with this approach. Of course, there is a vast amount of trading going on in advance of important announcements. Who but a nit-wit – or someone who has not read the academic literature for fifty years - could be surprised at that? Anyone who even casually watches stock price movements can observe that occurrence. However, that is a long way from establishing that illegal insider trading is occurring, though undoubtedly that is part of it. Probably, as enforcement has improved over the years, so have the techniques of hiding or obfuscating or sanitizing what would constitute illegal insider trading.

But the problem with the kind of approach taken in the instant study is that the same stock price effect can be had with gamblers and partially informed traders, not one of whom has specific, total information about a forthcoming event, trading on their assumed information. Some of the trading, for example, may be by employees of the traded company, or even mere standers by, who notice increased phone and courier business with lawyers and bankers and “bet” on this information though they do not know anything else. Is that a “significant” bit of information? Would we want to stop all such trading? Wouldn’t competitors and suppliers and customers often be in positions to infer that something “tradable” was up with a company even though they did not know what it might be?

There are always going to be lots of folks good at ferreting out trading signals from what may be perfectly innocuous activities to the rest of us, and it will remain forever impossible to totally isolate every observable aspect of a major corporate event. Who could do business that way? And how much of the observed trading, even of large blocs, is “derivative” (and therefore not actionable) of a small amount of informed trading. And how much input from people with low-probability, partial information is required before the “correct” price emerges via a “wisdom-of-crowds” mechanism? No one has even a clue to the answers to these questions.

All of this fits into the category of reasons why IT laws are generally not enforceable. But far too little interest has been shown in the problem of fractional enforcement of laws, a source of myriad unforeseen consequences. It seems that the more we learn about insider trading, the more we realize that we do not know enough abut what is going on to regulate it intelligently. And this certainly supports Larry Ribstein’s counsel that if we really do not know what the untoward consequences of a regulation are, we are probably better off without it, especially when we do know that the status quo has some real benefits.

Ridge Mazzoni Home Ranch (Sonoma County) 2001

This wine is actually a blend of 45% Zinfandel, 50% Carignane, and 5% Petite Sirah. Acceptable, but not exceptional.The dominant flavor association is the odd, slightly sour cherry-ish fruit I've begun to associate with Ridge ATP zinfandel-based blends. Firm, with plenty of acidity. Try it mid-winter with a rich stew. Grade: B--

A Shot Across Many Bows

From my latest TCS column:

As expected, various and sundry Islamic leaders are criticizing Pope Benedict's Regensburg speech. The LA Times reports:

"Pope Benedict XVI flew back to Rome on Thursday to face an international flurry of protest over comments he made critical of historical Islamic violence during a six-day trip to his native Germany.

"Muslim clerics and community leaders from Europe to the Middle East and beyond condemned the pope's comments made this week."

Both the Times (not surprisingly) and the Muslim leaders, of course, have missed the point. Benedict's remarks (which you can read in full here) must be understood in the context of his theology as a whole.

Jesus claimed "I am the way, the truth, and the life. No one comes to the Father except through Me." John 14:6. As C.S. Lewis put it of this claim:

"A man who was merely a man and said the sort of thing Jesus said would not be a great moral teacher. He would either be a lunatic -- on a level with the man who says he is a poached egg -- or else he would be the Devil of Hell. You must make your choice. Either this man was, and is, the Son of God: or else a madman or something worse. You can shut Him up for a fool, you can spit at Him and kill him as a demon or you can fall at his feet and call Him Lord and God. But let us not come with any patronizing nonsense about His being a great human teacher. He has not left that open to us. He did not intend to."

In a 2002 interview, then-Cardinal Ratzinger came down clearly and emphatically on the side of the Son of God:

"Christ is totally different from all the founders of other religions, and he cannot be reduced to a Buddha, a Socrates or a Confucius. He is really the bridge between heaven and earth, the light of truth who has appeared to us."

Also in 2002, when presenting the Congregation for the Doctrine of the Faith's Declaration "Dominus Iesus": On the Unicity and Salvific Universality of Jesus Christ and the Church, the then-Cardinal condemned the belief that "all religions are equally valid roads to salvation for their followers." He explained:

"This is a widespread conviction today not only in theological environments, but also in ever greater sectors of Catholic and non-Catholic public opinion, especially those most influenced by the cultural orientation that prevails in the West today, which can be defined, without the fear of contradiction, by one word: relativism."

In turn, he argued, relativism leads ineluctably to the "refusal to identify the historical figure of Jesus of Nazareth with the very reality of God, the living God."

Some of Benedict's predecessors -- arguably including his immediate predecessor John Paul II, who is otherwise well-deserving of his fast track to sainthood -- downplayed this aspect of Christian theology in order to promote inter-faith dialogue. In contrast, it is a core part of Benedict's faith and is rapidly becoming a major theme of his pontificate.

If Islamic leaders expect Pope Benedict to treat Islam as an "equally valid" "road to salvation," they are thus sure to be disappointed.

If rejecting the relativism constitutes a shot across Islam's bow, that shot also crosses any number of other bows. In the Regensburg speech, the Pope staked out a set of claims about the relationship of man and God that stand in opposition not only to the Islam of Ibn Hazn, but also that of the Protestant Reformers, the Jesus of History crowd, and (an area of particular concern for this pope) post-Christian Europe. The Pope renewed the claims of the Church Universal to have a truth that is transcendent, rather than culturally-bound:

"True, there are elements in the evolution of the early Church which do not have to be integrated into all cultures. Nonetheless, the fundamental decisions made about the relationship between faith and the use of human reason are part of the faith itself; they are developments consonant with the nature of faith itself." 

Having said that, of course, I concede that the Pope does seem to have the problem of religiously motivated terror in mind. Even so, Islam was not his only target. He said:

"A reason which is deaf to the divine and which relegates religion into the realm of subcultures is incapable of entering into the dialogue of cultures."

I read that line as a shot across the bow of post-Christian Europe -- a warning that Europe increasingly lacks the tools demanded to meet the threats of the day. Hence, the speech implicitly recalls what may be the ultimate goal of Benedict's pontificate; namely, calling Europe back to Christ.